Milestone 3: Pay Off Toxic Debt
At this point, you should have completed your budget, saved at least $1,000 in cash, begun taking advantage of your employer’s matching dollars, and are ready to move on to Milestone #3: Pay Off Toxic Debt.
- Starting Point: Creating Your First Budget
- Milestone 1: The Uh-Oh Fund
- Milestone 2: Take Advantage of Your Employer Match
- Milestone 3: Pay Off Toxic Debt
- Milestone 4: Fully Funded Emergency Fund
- Milestone 5: Save 15%-25% of Your Income in Tax-Advantaged Retirement Accounts
- Milestone 6: Save for Flexibility in Bridge Accounts
- Milestone 7: Prefund Kids’ Expenses
- Milestone 8: Pay Off Remaining Debt
- Milestone 9: Total Financial Independence
Debt is a financial topic that generates a wide-reaching variety of opinions about what is and isn’t constructive.
Some despise debt entirely and believe one dollar of debt is a dollar too much. Others embrace leverage like it’s the very air they breathe.
Both extremes have their own pros and cons.
On the ultra-conservative end, it’s not very realistic to expect most people to be able to cashflow major life expenses like education and housing. It could take years to accumulate the funds for endeavors like these which could severely limit one’s quality of life.
On the other hand, if you’re too eager to utilize debt for life’s general expenses, even a short-lived disruption to cash flow could push you over the edge of bankruptcy and financial ruin.
The best metaphor I’ve heard regarding debt comes from Brian Preston of The Money Guy Show.
He compares debt to a chainsaw.
Obviously, a chainsaw can be very effective and useful when handled properly.
On the other hand, if used incorrectly, the consequences of careless chainsaw use can be gruesome or even fatal.
Without going any further into this graphic example, I’ll summarize by assuming that we can all agree that debt should be handled with care.
With that in mind, let’s start by taking a look at different kinds of debt so we can delineate the benefits of debt from its dangers.
Debt Categories & Types
In my opinion, the easiest way to highlight the benefits and dangers of debt is to classify it in a couple of different ways.
There are certainly approaches to categorizing debt other than the next two concepts I’ll be walking through, and I will get to some of those in a bit, but by focusing on just a couple of characteristics of various debts we can quickly get a clearer picture of whether or not certain debts are “good” or bad”.
Hopefully, this will make decisions about debt a little easier for you as you weigh your options.
Secured vs Unsecured
First, it’s important to understand the differences between secured and unsecured debt.
Secured debt is money loaned to a party that is backed up or “secured” by some form of collateral.
Mortgages and car loans are common examples of secured debt.
Typically, you will see lower interest rates associated with secured debt because if you fail to repay your lender according to the terms of your loan agreement, they can legally seize the collateral (like your house or car) and sell it to recoup the money they let you borrow.
In this way, collateral acts as a backstop or insurance for the lender in case the borrower fails to repay their loan. This significantly lowers the risk for the lender.
Conversely, unsecured debt is debt that is issued without collateral. And, as you could probably guess, unsecured debts typically have higher interest rates.
Credit cards are the most common example of unsecured debt, but student loans are another major player in this category because lenders can’t repossess an education from the brain of a borrower.
Appreciating vs. Depreciating Assets
The second debt categorization to make is whether or not the money borrowed is for the sake of buying an appreciating or depreciating asset.
An appreciating asset is something that gains value or “appreciates” over time.
Houses are a great example of an appreciating asset. Generally, the value of a home tends to increase with time making it more valuable after years of ownership than when you first purchased it.
A depreciating asset is something that loses value or “depreciates” with time.
Cars and consumer goods are both examples of depreciating assets.
Good Debt & Bad Debt
Now that we have an understanding of secured/unsecured debts and appreciating/depreciating assets, let’s take a look at the relationship between these ideas and how they can drive our decisions about debt.
Below is a simple chart illustrating these relationships and highlighting a few examples of each. The hotter colors represent higher-risk debts that should be avoided.
The bluer side of the chart contains debts that are typically lower risk and represent potentially healthier ways to use leverage. Conversely, the areas that are red represent riskier or more dangerous types of debt.
The Four Debt Quadrants:
Secured/Appreciating – Okay If Affordable
This is the safest and wisest form of debt because having a secured asset that appreciates should allow you to find low interest rates and provide the financial benefit of capital appreciation in the asset that debt is used to buy. The only way to get into trouble here is by borrowing more than you can reasonably afford to pay back. But, even if that happens, you have an appreciating asset that you can sell to get yourself out of the deal.
Secured/Depreciating – Use With Great Caution
Having collateral can make interest rates for these loans tolerable, but your overall net worth will take a hit from this loan because you will lose money through 1) paying interest, and 2) the decreasing value of the asset. Over time, this can add up to hundreds of thousands, even millions of dollars. I would avoid this type of debt if possible.
Unsecured/Appreciating – Use With Caution
The fact that these loans are unsecured places most of the risk on the lender meaning interest rates are typically higher. The good news for you as a borrower is that there is no asset in this case that can be repossessed and sold by the lender. Likewise, there’s no asset for you to sell in order to get out of the loan, meaning you can find yourself in a great deal of trouble if you aren’t wise about borrowing money in this quadrant.
Unsecured/Depreciating – Avoid
This is the riskiest, least desirable form of debt for you as a borrower. Lenders cover their additional risks in this category by charging high levels of interest on the amounts they loan. Worse yet, as a debtor in this quadrant, you won’t be able to sell the assets you purchased with the borrowed money, making it difficult to pay off the loan if you’re strapped for cash. If you picture the graph as a funnel toward bankruptcy, this quadrant has the shortest path to financial disaster. Stay away.
Specific Debt Types
Hopefully, you like visual aids like the chart, but it’s a somewhat generalized tool for evaluating debt at a very high level.
Here are some more direct thoughts and comments I have about common types of debt…
Mortgages
Fixed rate mortgages are an easy yes for me. Homes are the primary net-worth building asset for most American families. A mortgage is one of the easiest debts to obtain and they come with many features to keep you out of trouble if you experience financial difficulty.
With that said, don’t borrow money for a house until you can afford it. I recommend keeping the combined costs for housing and transportation expenses below 30% of your monthly income. This is to ensure that you have money left to focus on upcoming milestones on the Next Dollar Roadmap.
HELOCs
A Home Equity Line of Credit (HELOC) can be a useful way to leverage the equity in your home as a quick source of cash. However, interest rates on HELOCs are typically higher than a mortgage which means you’re paying higher interest for debt on the same asset.
A common practice for many is to use a HELOC as an emergency fund. The major issue with this is the bank can withdraw this line of credit at any time meaning it may not be available when you need it most.
There are uglier forms of debt, but I recommend avoiding HELOCs if possible.
Car Loans
I don’t recommend taking on debt to buy a car. It’s not a very common or even popular opinion, but it is based on math.
My personal view is that car debt is the single most destructive force against wealth building there is. For more about that, check out my YouTube video that explains how paying cash for cars over the course of 30 years could result in a net swing of more than $1.14 MM in personal net worth.
Student Loans
Student loans can be a wise way to fund an investment in your future. There’s no doubt that the long-term benefits of education make post-secondary study a worthwhile pursuit.
However, the expectation of a higher salary doesn’t necessarily justify taking on unchecked levels of debt. There’s a big difference between borrowing $150,000 for a degree in 2nd-century Greek architecture and putting yourself through medical school.
To keep your student loans between the guardrails, don’t borrow more than 1 to 2 years of your expected salary upon graduation. This will ensure you have enough income to direct toward your loans and start investing if you need to.
Appliances & Furniture
Don’t borrow money for household items. The interest is normally very high, and it shouldn’t take very long to set aside cash for these purchases instead.
Credit Cards
While I see a lot of benefits and convenience related to using credit cards to cover day-to-day purchases, you absolutely should not carry a credit card balance from month to month. If you can’t pay off your credit cards each month, you need to chop them up and toss them.
Payday Loans
These things are awful. Stay away.
If you look up “predatory lending” in the dictionary, there very well could be a photo of a payday loan office next to the definition.
Toxic vs Non-Toxic Debt
Right out of the gate, we defined and discussed secured vs. unsecured debts and appreciating vs. depreciating assets. I highlighted these first to point out the types of debt that should be avoided.
However, now that we’re shifting the discussion from what types of debt to take on to what types of debt to pay off, there’s a third debt delineator I’d like to introduce: Toxic vs Non-Toxic Debt.
Toxic Debts are debts that aggressively erode your net worth because they either have very high interest, depreciate in value, or both.
Toxic Debts represent an urgent priority for your finances because of their highly destructive nature.
These debts are typically found in the hotter zones of the heatmap I presented above.
Providing specific criteria for classifying debts as Toxic is a bit of a challenge because the standard moves a bit with economic forces.
For example, as I am writing this in the Fall of 2024, you can take out a loan on a new automobile at around 6% to 16%, depending on your credit.
When my wife and I bought our last car just three years ago in the Fall of 2021, we were offered a loan with an interest rate of 2.625%.
That is a very significant difference in interest rates and it’s also an example of why I can’t arbitrarily make suggestions like, “Car loans are toxic, but mortgages aren’t.” or “Student loans are great, but HELOCs are financially radioactive!”
The definition of Toxic Debt depends on a number of factors like your age, the amount of liquid cash you have available, the asset you’re borrowing against, prevailing interest rates, etc.
Although I can’t completely remove the ambiguity, here are a couple of ways to think about Toxic Debt.
First, the highly subjective but quick way to identify Toxic Debt is to compare your age with the interest rate of the debt.
Using this as a basis, if you’re in your 20s and the interest rate on a loan is over 6%, or you’re in your 30s and the interest rate is over 5%, or you’re in your 40s and the interest rate is over 4%, then it’s Toxic Debt.
If you’re in your 50s or older, I generally suggest paying off the debt no matter what it is.
Like I said, that’s the quick and dirty way to define Toxic Debt, and if it works for you, then great. But if I’m being honest, there are exceptions to this generalized standard.
So, if you want a more nuanced answer, the truth is Toxic Debt should be defined as any debt with an interest rate that exceeds the expected rate of return for any low-risk investments you would direct the money into if you weren’t paying off debt.
I specifically referenced low-risk investments because there isn’t any risk to you in paying off debt. If you have a loan with a 5% interest rate, then any amount you pay back is going to save you 5%. It’s virtually guaranteed (unless the rate floats, in which case it’s definitely toxic).
For example, if you have a mortgage with an interest rate of 3% and you can reasonably expect an investment that aligns with your chosen asset allocation to outperform the 3% cost of the debt, then you should direct the minimum amount toward your mortgage and any extra cash that you could have used to pay down the debt should be invested instead.
On the other hand, if you have a car loan with an 8% interest rate then it’s Toxic and you should pay it off because you can’t reasonably expect an investment to return a guaranteed amount that’s greater than 8%.
For a benchmark of interest rates on low-risk investments, just look up treasury yields and grab the rate for whatever security matches a similar payoff timeline to your debt. As an example, you can use a 3-year treasury note for a loan that has a 3-year term or a 20-year bond rate for a mortgage with 22 years remaining.
These rates change and, as a result, your definition of “Toxic Debt” may need to move with it.
Technical explanations aside, I rarely define a conventional mortgage as toxic for three reasons:
- Mortgages take a long time to pay off, even if you aggressively attack the principal. Those are years you should use to get started in investing instead.
- Because mortgages are secured debt, they typically have low interest rates compared to other forms of debt.
- You can refinance a mortgage when rates come down which will allow you to obtain a lower, non-toxic rate even if your current rate is relatively high.
Furthermore, I rarely consider virtually any other form of debt as non-toxic with the exception of student loans or medical debts with low interest rates.
When in doubt, I would recommend that you consider the debt toxic and pay it off.
Paying Off Debt
The final concept I want to cover is how to prioritize debts you’re focused on paying off. There are two primary ways to approach eliminating debt, the Debt Avalanche and the Debt Snowball.
Debt Snowball
The debt snowball method calls for borrowers to pay minimum monthly balances on each debt before directing any remaining funds to debts from the smallest to the largest outstanding amount, regardless of the interest rate.
While not the most efficient approach monetarily, this is the fastest path to chalking up a mental victory on your debt reduction journey.
If you feel that you would benefit from the psychological boost of a quick score in the win column against debt, this may be the route for you.
For example, let’s assume Danny Debtor has the following debts:
- $30,000 student loan at 5% with a monthly minimum payment of $200
- $10,500 car loan at 6% with a minimum monthly payment of $250
- $15,000 credit card debt at 15% with a minimum monthly payment of $150
After creating a robust budget and paying all necessities and minimum required payments to his debts, Danny has $1,500 per month to direct toward paying off his debts early in addition to the monthly minimum payment amounts.
Using the snowball method, Danny would begin by making the minimum monthly payments on the student loan ($200) and credit card ($150) before directing the remaining $1,500 toward his car loan.
After 7 months Danny would have eliminated his car loan, incurred a total of $210 in interest on the loan, and begun working toward paying off his credit card debt.
With the car loan out of the way, Danny now has an additional $250/month to direct toward his next debt: credit cards.
At $1,750 each month, Danny will have his credit cards gone in a little over 8 months and incur $1,895.63 in interest. Now Danny has another $150/month to attack the student loans.
At $1,900 per month, it would take Danny 15 months to pay off the student loans. However, by paying the monthly minimum for the previous 15 months as he was focused on the car loan and credit cards, Danny now owes $27,000.
As a result, he pays off his last debt a little over 13 months later and incurs $2,672.08 in interest while paying down the debt.
All told, using the debt snowball method Danny paid off his debts in about 28.5 months and incurred interest expenses of $4,777.71 during the paydown period.
Debt Avalanche
On the other hand, if you want to pay your debts in the most cost-effective manner possible, the debt avalanche is the way to go.
The debt avalanche method means you’ll contribute the minimum payments on each debt, then contribute the remainder to your highest interest debt, regardless of the amount, before moving to the 2nd highest rate, and so on.
As a result, each dollar you contribute to debt paydown has the biggest possible impact because it is paying off borrowed amounts at the highest interest rates.
Remember, if your highest-interest debt also happens to have the highest interest rate it may take some time to completely eliminate your first debt and get that mental boost.
Let’s see what happens if Danny Debtor uses the debt avalanche. Remember Danny has the following debts:
- $30,000 student loan at 5% with a monthly minimum payment of $200
- $10,500 car loan at 6% with a minimum monthly payment of $250
- $15,000 credit card debt at 15% with a minimum monthly payment of $150
This time Danny starts with the credit cards since that interest rate is the highest. It takes him 10 months to eliminate the debt and he incurs $1,031.25 in interest while paying it off.
Moving on to the car loan, Danny pays it off 4 months later and incurs interest charges of $551.25.
Finally, Danny pays off the student loans after an additional 15.5 months and incurs interest expenses of $2,678.33.
All told, Danny pays off the same debts in 29.5 months at a total interest cost of $4,260.83.
So, by using the debt avalanche Danny took roughly an extra month to pay off the debt, but it saved him a total of $516.88 in interest over the paydown period.
This was a simple example. The interest costs and pay-down periods could vary greatly depending on your situation, but hopefully, this gives you some idea of how these methods work.
Wrap Up
That is a bunch of information about debt and I hope you found it helpful. Paying off debt is probably the toughest lift on the entire Next Dollar Roadmap.
It’s not much fun directing your available cash into something that you don’t see a regular tangible benefit from. Depending on your past financial choices, this milestone can also take quite a bit of time to complete.
However, the feeling when you finish will be totally worth it. Having more disposable income that you can begin to put to work on your behalf is incredibly refreshing and the journey quickly improves from there.
Next stop, Milestone 4: Fully Funded Emergency Fund.
